Apr 3, 2009

What Is The Multiplier Effect?

cumulative effect of change: the idea that increased spending in one part of the economy will lead to bigger effects in other parts. For example, increased government spending will lead to increased activity in companies, with employees earning more, which will lead to increased spending on consumer goods.

The marginal propensity to consume (MPC) is equal to ΔC / ΔY, where ΔC is change in consumption, and ΔY is change in income. If consumption increases by eighty cents for each additional dollar of income, then MPC is equal to 0.8 / 1 = 0.8.

The expenditure multiplier is the ratio of the change in total output induced by an autonomous expenditure change.

Some consumption is considered to be autonomous. Even with no income, some consumption will occur (savings will need to be used). So the consumption function could be expressed as C = α + (β × Y), where α represents consumption that occurs regardless of income, β is the marginal propensity to consume and Y is income.

Why is there a multiplier effect?

Suppose a large corporation decides to build a factory in a small town and that spending on the factory for the first year is $5 million. That $5 million will go to electricians, engineers and other various people building the factory. If MPC is equal to 0.8, those people will spend $4 million on various goods and services. The various business and individual receiving that $4 million will in turn spend $3.2 million and so on.

If the marginal propensity to consume is equal to 0.8 (4 / 5), then the multiplier can be calculated as:

Multiplier = 1 / (1 – MPC) = 1 / (1 – 0.8) = 1 / 0.2 = 5

As a result of the multiplier effect, small changes in investment or government spending can create much larger changes in total output. A positive aspect of the multiplier effect is that macroeconomic policy can effect substantial improvements with relatively small amounts of autonomous expenditures. A negative aspect is that a small decline in business investment can trigger a larger decline in business activity and, thereby, create instability.

The previously mentioned formula for calculating the multiplier is a simplified one. Leakages (money spent, but not on domestic goods or domestic services) reduce the size of the multiplier. Examples of leakages include taxes and imports.

Another important point is that the multiplier effect takes time to work; months must pass before even half of the total multiplier effect is felt. Also, keep in mind that the multiplier effect can cause idle resources to be moved into production. If unemployment is widespread, then there should be little impact on resource prices.

The expansion of a country's money supply that results from banks being able to lend. The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is money used to create more money and is calculated by dividing total bank deposits by the reserve requirement.

Investopedia explains Multiplier Effect

The multiplier effect depends on the set reserve requirement. So, to calculate the impact of the multiplier effect on the money supply, we start with the amount banks initially take in through deposits and divide this by the reserve ratio. If, for example, the reserve requirement is 20%, for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64. This cycle continues - as more people deposit money and more banks continue lending it - until finally the $100 initially deposited creates a total of $500 ($100 / 0.2) in deposits. This creation of deposits is the multiplier effect.

The higher the reserve requirement, the tighter the money supply, which results in a lower multiplier effect for every dollar deposited. The lower the reserve requirement, the larger the money supply, which means more money is being created for every dollar deposited.

For example: a company spends $1 million to build a factory. The money does not disappear, but rather becomes wages to builders, revenue to suppliers etc. The builders will have higher disposable income as a result, so consumption, hence aggregate demand will rise as well. Suppose further all of the recipients of new factory spending in turn spend it.

The increase in the gross domestic product is the sum of the increases in net income of everyone affected. If the builder receives $1 million and pays out $800,000 to sub contractors, he has a net income of $200,000 and a corresponding increase in disposable income (the amount remaining after taxes).

This process proceeds down the line through subcontractors and their employees, each experiencing an increase in disposable income to the degree the new work they perform does not displace other work they are already performing. Each participant who experiences an increase in disposable income then spends some portion of it on final (consumer) goods, according to his or her marginal propensity to consume, which causes the cycle to repeat an arbitrary number of times, limited only by the spare capacity available.

Another example: when tourists visit somewhere they need to buy the plane ticket, catch a taxi from the airport to the hotel, book in at the hotel, eat at the restaurant and go to the movies or tourist destination. The taxi driver needs petrol (gasoline) for his cab, the hotel needs to hire the staff, the restaurant needs attendants and chefs, and the movies and tourist destinations need staff and cleaners.

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"Make peace with the universe. Take joy in it. It will turn to gold. Resurrection will be now. Every moment, a new beauty." - Jallaludin Rumi

"God is a metaphor for that which transcends all levels of intellectual thought. It's as simple as that." - Joseph Campbell

"Naturally, every age thinks that all ages before it were prejudiced, and today we think this more than ever and are just as wrong as all previous ages that thought so. How often have we not seen the truth condemned! It is sad but unfortunately true that man learns nothing from history." - Carl Jung

"Of all the animosities which have existed among mankind, those which are caused by difference of sentiments in religion appear to be the most inveterate and distressing, and ought most to be deprecated. I was in hopes that the enlightened and liberal policy, which has marked the present age, would at least have reconciled Christians of every denomination so far that we should never again see the religious disputes carried to such a pitch as to endanger the peace of society." - George Washington

“Be empty of worrying. Think of who created thought! Why do you stay in prison. When the door is so wide open?” ― Rumi

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